If a group has established an arm’s-length transfer pricing policy that is working well in all the countries in which it operates, how should it deal with the situation when a new law in one of its territories means that existing policies are no longer acceptable in that particular country? All cross-border transactions have an impact on the accounts of at least two separate legal entities, and if a policy is changed to meet the requirements of one country’s laws, will the new policy be acceptable to the country affected on the other side of the transaction? While the arm’s-length principle is widely recognised, individual countries have different views of exactly what this means. There is, therefore, always a risk of asymmetric treatment of transactions for tax purposes in different jurisdictions, resulting in double taxation.
A group’s reaction to the different legal requirements, country by country, will necessarily be driven by its evaluation of the tax risks involved. If it seems inevitable that one particular country will apply its laws aggressively, resulting in double taxation if the group’s policy for that country is not altered, then it may be necessary to amend the policy to produce the lowest tax result for the group as a whole. In these cases, monitoring the position in other countries will be of crucial importance.
Example
Cool EC (Cool) is a group of companies engaged in the manufacture of refrigerators operating entirely within the European Union (EU). Cool’s engineering department is located in the UK company (Cool UK) and has for many years provided technical assistance to the group’s sales companies throughout the EU. The services have been provided under the terms of a formal agreement, and charges are made for the engineers’ time and expense in exactly the same way as charges are invoiced to third-
party customers for the same services. This arrangement has been accepted by all the EU tax authorities, with the result that the service income is taxed only in the UK and tax deductions for the same amount are taken in the paying companies.
Cool has recently secured a large order for its machines from the biggest distributor of domestic electrical goods on the African continent. New subsidiaries will be established to service this market and to deal with customer services. However, as with the EU operations, Cool UK’s engineers will also be required to provide their services from time to time. Unfortunately, Cool UK has found that it is likely to suffer extensive taxes if it seeks to charge for the engineers’ services in the same way as in the EU countries. The position varies in detail from country to country, but the range of problems include the difficulties in arranging foreign exchange clearances to obtain currency, withholding taxes, local sales taxes and, in certain cases, direct local taxation of the full service charge on the basis that the services represent a permanent establishment of Cool. Cool UK has calculated that the effective tax rate on the service fees could exceed 80% in certain circumstances, in addition to causing cash-flow problems.
How then, should Cool UK react to this significant problem? There are three main options:
• The group could pursue a policy consistent with the present arrangements in Europe, which would be supported by the third-party comparables.
• The group could decide that no charge be made, on the basis that the tax rate effectively wipes out any benefit.
• The group could find an entirely new way of dealing with the problem. The first option is unacceptable due to the resulting high tax rate.
The second option will probably give rise to transfer pricing questions in the UK. The Inland Revenue will not accept that free services should be provided over an extended period to overseas affiliates and are likely to assess a deemed amount of income to UK tax. There is also the possibility that the other EU authorities could challenge the charges made to them if Cool’s UK operation sought to increase the inter-company service charges to its European affiliates to offset the loss-making African service. After lengthy negotiations, Cool UK finds that the African authorities are prepared to give full foreign-exchange clearances for payments for the refrigerators, and no other African withholding taxes would be applied to these payments. If the transfer price of the refrigerators can be increased to cover the expected cost of service by the UK engineers, then the UK authorities are unlikely to complain. Careful documentation will be needed to support the pricing. In particular, it will be helpful to monitor what the normal charge for the engineers’ time on African affairs would have been and how this compares with the recovery made through the transfer price. It will also be relevant to consider if the increased transfer price would cover the estimated cost of maintenance services over the warranty period alone or would also cover after-sales service, which may be normally paid for by the end-customers. Consideration must also be given to the cost of spares, which would have to be imported for the service. One possibility is to increase the price of spares to cover the service component. Finally, it must be borne in mind that increasing the transfer price will increase the base on which African customs duties will be calculated. This hidden tax must also be evaluated in making the final decision on how to proceed.
Input from Cool’s transfer pricing committee will be helpful in smoothing over management difficulties, which might otherwise arise. In particular, in this example, the head of the engineering department had been concerned that one result of recovering the value of engineering services through the transfer price of products would be that the apparent profitability of his division would decrease while the sales department’s income would go up by a corresponding amount. As both managers receive bonuses calculated on divisional profits, there is an apparent conflict between their personal interests and those of the business. One solution may be for the bonus scheme to make adjustments for the African business. Alternatively, the engineering department could render an internal invoice to the sales department.